Mortgage debt relief

In previous years, homeowners who lost their homes or sold them in a short sale were still expected to pay taxes on any debt forgiven by a bank or lender. Just when you thought you had gotten out of a pickle, Uncle Sam would hit you with a tax bill because the Internal Revenue Service looks at that forgiven debt as taxable income.

But a new tax law, called the Mortgage Debt Relief Act of 2007, allows taxpayers to exclude up to $2 million of mortgage debt forgiven in 2007, 2008 or 2009. For a married person filing a separate return, the limit is $1 million. This applies only to your principal residence. Sorry, you can’t claim this relief for second homes, investment property, credit card debt, car loans or business property.

Here’s more from the IRS:

Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, may qualify for this relief. In most cases, eligible homeowners only need to fill out a few lines on Form 982 (PDF) (specifically, lines 1e, 2 and 10b).

The debt must have been used to buy, build or substantially improve the taxpayer’s principal residence and must have been secured by that residence. Debt used to refinance qualifying debt is also eligible for the exclusion, but only up to the amount of the old mortgage principal, just before the refinancing.

Congress passed the law late last year so check to make sure your tax software includes this update, the IRS warns. Your lender should also have filed a 1099-C for you.